Cryptocurrencies may be all the rage, but good luck figuring out how they fit in a portfolio.
Money managers generally try to maximize gains and limit losses by estimating the expected risk and return of various investments and then assembling a mix that offers the best trade-off between risk and return.
The most widely used measure of risk is volatility, or standard deviation in finance speak. For traditional investments such as stocks and bonds, historical averages are a good gauge of future price swings because volatility tends to hug a tight range over multiyear periods.
Estimating future returns is trickier. Investors can rely on historical averages there, too, and many do. But while multiyear returns often approximate their historical average, they occasionally vary from it by wide margins, usually during market extremes.
Gauging Yearly Returns
One way to handle those extremes is to deconstruct the drivers of returns. For example, most of the payoff from bonds comes from their yield, and bond yields in the U.S. are at historic lows.
So while long-term government bonds have returned about 6% a year over the past 100 years, the current yield on 30-year Treasuries of just 2.4% signals that returns are likely to be a lot lower going forward.
Stocks are a bit more involved, but the idea is the same. U.S. stocks have returned about 9% a year over the past 150 years, broken down into 2% inflation, 2% real (net of inflation) earnings growth, 4.5% dividend yield and 0.5% valuation expansion.
Looking ahead, the bond market expects inflation of 2.5% a year over the next 10 years; real earnings growth might be closer to 2.5% if U.S. companies can maintain their recent pace; the dividend yield for the S&P 500 Index is about 1.5%; and with the stock market at or near record high valuation, further expansion is probably a stretch.
That adds up to an expected return of 6.5% a year from U.S. stocks.
Sure, estimating future returns involves judgment, and investors often disagree on the numbers. But none of that analysis is even possible with cryptocurrencies.
Bitcoin, the oldest of them, has been around for only 13 years, so the record isn't long enough to rely on. And it almost certainly isn't indicative of the future.
Bitcoin has returned about 220% a year during its short life, which is obviously unsustainable. Its annualized standard deviation has been 200% over the same time, making its volatility about 15 times that of the S&P 500 and more than 60 times that of bonds.
As cryptocurrencies become more established, their returns and volatility are likely to drop significantly.
